VOLUMETRIC PRODUCTION PAYMENTS Liz McGinley
What is a Vlumetric Prductin Payment ( VPP )? A nn-perating, nn-expense bearing, limited term ryalty. It entitles the hlder t a specified vlume f hydrcarbns (r prceeds frm the sale f such hydrcarbns) prduced frm the prperty each perid. The interest cnveyed is typically, althugh nt necessarily, characterized as a real prperty interest. The term f the cnveyance cntinues until a specified quantity f hydrcarbns has been prduced. The prductin is delivered t the VPP hlder free f csts and free f taxes. N recurse t the issue r ther assets f the issue. Favrable treatment under U.S. bankruptcy law and U.S. federal incme tax law. 2
Hw des a VPP wrk? Typically, the purchaser makes a single upfrnt cash payment t the issuer in exchange fr scheduled vlumes f mnthly prductin t be delivered t the purchaser. The vlumes may be delivered in kind, r sld by the issuer, and the sale prceeds delivered t the VPP purchaser. Shrtfalls in delivery are t be made up in the next mnth. The shrtfall quantity is adjusted fr the next mnth's cmmdity price plus interest. The terms f the VPP transactins are dcumented by: Purchase and Sale Agreement Cnveyance f Ryalty Interest Prductin and Marketing Agreement 3
Advantages f VPP Financing VPPs are cnveyances f prperty interests and when the VPP is granted, the related prductin is treated as utside f the issuer s (debtr s) estate. Upn a declaratin f bankruptcy by the issuer, delivery f prductin is nt subject t the autmatic stay. Enfrcement f cvenants and related cllateral will be subject t the stay. Issuer maintains peratinal cntrl. Effective hedge fr issuer. Hlder f the VPP bears cmmdity price and interest rate risk. Hlder has n liability fr perating csts r expenses. 4
Risks f VPP Financing Reserve Risk. Because the hlder nly is entitled t receive its return frm the prductin frm the specified leases, the hlder must rely slely n the sufficiency f the related reserves t prduce the scheduled hydrcarbns. This risk can be mitigated by perfrming due diligence n the reserves and sizing the VPP s satisfactin des nt require the prductin f a large majrity f the anticipated reserves, rather clser t 40-50%. Establishing a VPP n diversified leases, rather than a limited number in a single area, als can reduce the risk. Cmmdity Price Risk. The hlder f the VPP assumes the risk that the hydrcarbns prduced cannt be sld at a price that will result in the hlder achieving n less than its anticipated return. The hlder can reduce this risk by entering int a cntract t resell the hydrcarbns at a fixed price and/r enter int a cmmdity price hedge. 5
Risks f VPP Financing (cntinued) Interest Rate Risk. The VPP hlder assumes the risk that interest rates will rise ver the term f the VPP and its return n the VPP will nt rise. The hlder can mitigate the risk by entering int hedging transactins. Operatinal Risk. The VPP hlder assumes the risk that the issuer will nt prudently perate the burdened prperties. The hlder can mitigate this risk by sizing the VPP s the prductin in each perid in excess f the VPP vlumes and the tail reserves remaining after the VPP is satisfied are sufficiently valuable s the issuer will be incentivized t cntinue prductin. 6
Hw is a Prductin Payment Defined fr Federal Incme Tax Purpses? Treasury Regulatin Sectin 1.636-3 defines prductin payment : A right t a specified share f prductin frm minerals in place (if, as, and when prduced) r the prceeds f such prductin. Must be an ecnmic interest in such mineral in place.» Treasury Regulatin 1.611-1(b)(1) defines an ecnmic interest as any interest in minerals in place that secures, by any frm f legal relatinship, incme derived frm the extractin f the mineral, t which the hlder must lk fr the return f its capital. A hlder f an ecnmic interest is entitled t depletin.» It may burden mre than ne mineral prperty. The burdened prperty need nt be an perating interest. 7
Hw is a Prductin Payment Defined fr Federal Incme Tax Purpses? (cntinued) Must have an expected ecnmic life (at the time f its creatin) f shrter duratin than the ecnmic life f ne r mre f the mineral prperties burdened thereby. The right may nt reasnably be expected t extend in substantial amunts ver the entire prductive life f such mineral prperty. It cannt have the right t be satisfied by ther than the prductin f minerals frm the burdened prperty. May be limited by dllar amunt (dllar prductin payment), quantum f mineral (vlumetric prductin payment) r a perid f time. Includes a right which is, in substance, ecnmically equivalent t a prductin payment, regardless f the language used t describe such right, the methd f creatin f such right, r the frm in which such right is cast. 8
Hw as a Prductin Payment Defined fr Federal Incme Tax Purpses? (cntinued) Revenue Prcedure 97-55 prvides the guidelines fr btaining a ruling that an arrangement is a prductin payment. The right is an ecnmic interest as defined in Treasury Regulatin Sectin 1.611-1(b) withut regard t the applicatin f Cde Sectin 636, The right is limited by a specified dllar amunt, a specified quantum f mineral, r a specified perid f time, It is reasnably expected, at the time the right is created, that it will terminate upn the prductin f nt mre than 90% f the reserves that are then knwn t exist, and The present value f the prductin expected t remain after the right terminates is 5% r mre f the present value f the entire burdened prperty (determined at the time the right is created). The determinatin f present value takes int accunt all the facts and circumstances in accrdance with Treasury Regulatin Sectin 1.611-2(e). 9
Hw are Prductin Payments Treated fr Federal Incme Tax Purpses? Cde Sectin 636(a) prvides that a prductin payment carved ut f mineral prperty shall be treated, fr purpses f subtitle A (incme taxes), as if it were a mrtgage lan n the prperty, and shall nt qualify as an ecnmic interest in the mineral prperty. The mrtgage lan is a cntingent payment debt instrument. Hwever, a prductin payment carved ut fr explratin and develpment f such prperty shall nt be treated as a mrtgage lan. A prductin payment is treated as carved ut fr explratin and develpment nly if:» The expenditure is necessary fr ascertaining the existence, lcatin, extent r quality f any depsit f mineral r is incident t and necessary fr the preparatin f a depsit fr prductin.» The cash is pledged fr explratin r develpment f the burdened prperty r the issuer has a binding bligatin t apply the prceeds fr the csts f explratin r develpment f the burdened prperty. Prductin payments may be interests in real prperty fr purpses f the FIRPTA rules. Treasury Regulatin Sectin 1.897-1(d). 10
Example On January 1, 2012, the wner f an perating interest sells a prductin payment burdening the prperty fr $1 millin. The prductin payment entitles the hlder t scheduled vlumes f natural gas. In 2012, the prperty prduces 100,000 units f natural gas with a market value f $300,000, f which 20,000 units with a market value f $60,000 were scheduled quantities delivered t the hlder. Owner des nt recgnize incme in cnnectin with the issuance f the prductin payment. In 2012 the wner includes in its taxable incme the $300,000 f prceeds frm prductin and takes deductins fr the related prductin csts. Owner s $60,000 payment t the hlder is characterized as part principal repayment and part interest expense. Owner is entitled t a deductin fr the interest paid. Hlder treats the $60,000 payment received as part principal repayment and part interest incme. Hlder is nt entitled t depletin. 11
Hw is the Interest Cmpnent f VPPs Determined? VPPs generally are treated as cntingent payment debt instruments issued fr cash and interest is determined under the nncntingent bnd methd. Treasury Regulatin Sectin 1.1275-4. Under the nncntingent bnd methd, a prjected payment schedule is created t determine peridic interest accruals. Subsequently, adjustments are made when actual payments differ frm prjected payments. 12
Hw is the Interest Cmpnent f VPPs Determined? (cntinued) Applicatin f the nncntingent bnd methd: Upn issuance, determine the cmparable yield.» The cmparable yield is the yield at which the issuer wuld issue fixed rate debt with the terms and cnditins f the cntingent debt (i.e., term, subrdinatin).» Shuld be supprted by cntempraneus dcumentatin. Cnstruct a prjected payment schedule using the cmparable yield.» This schedule is created at issuance and is nt mdified during the term f the VPP. 13
Example: Prjected Principal Interest $1,000,000 $300,000 $1,000,000 $240,000 $1,000,000 $180,000 $1,000,000 $120,000 Actual $1,300,000 $1,250,000 $900,000 $1,120,000 Interest deductin/incme: 1 = $300,000 prjected amunt, n adjustments 2 = $240,000 prjected amunt + $10,000 additinal interest 3 = $180,000 prjected amunt - $180,000 negative adjustment plus rdinary incme/less rdinary lss f $100,000 4 = $120,000 prjected amunt, n adjustment 14
Typical Syndicated VPP E&P C VPP gas Trust Ntes Lenders Gas sales at index Ntinal Q x fixed Ntinal Q x index Gas Market Trade Desk 15
VPPs in Lw Price Envirnments Upside VPPs E&P C VPP gas Trust Ntes Lenders Gas sales at index $[5.00] participating flr The vlume under the VPP ges dwn as the price rises abve $[5.00] n a participating basis. Gas Market Trade Desk 16
Hw is the Interest Cmpnent f VPPs Determined? (cntinued) Determine the daily interest accrual. Adjust accrued interest r deductin when actual payments are made.» Net all psitive and negative adjustments in the same tax year.» A net psitive adjustment is treated as additinal interest.» A net negative adjustment: First, ffsets the current year interest accrual, Secnd, is treated as rdinary incme by the issuer r rdinary lss by the hlder t the extent f the sum f the interest reprted n the VPP fr prir perids net f adjustments, and Third, any remaining negative adjustment is carried frward t ffset interest accruals and any amunt remaining when the VPP is sld r matures is treated as a reductin in the amunt paid r received in such sale r retirement. 17
CIRCULAR 230 TO ENSURE COMPLIANCE WITH TREASURY DEPARTMENT CIRCULAR 230, YOU ARE HEREBY NOTIFIED THAT ANY DISCUSSION OF U.S. FEDERAL INCOME TAX ISSUES HEREIN IS NOT INTENDED OR WRITTEN TO BE RELIED UPON, AND CANNOT BE RELIED UPON, BY ANY PERSON FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED REGARDING THE TRANSACTIONS OR MATTERS ADDRESSED HEREIN. 18 4274882
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CONTACT Liz McGinley Partner T: E: +1.212.508.6173 liz.mcginley@bracewell.cm 20
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